What is the Capital Stack? Priority of Claims in Finance

The capital stack defines the legal hierarchy of different types of capital used to finance an asset, determining the order of payment and risk.

The Capital Stack refers to the legal hierarchy of all capital invested in a business or asset. It determines who gets paid first and who bears the most risk in the event of a liquidation or bankruptcy. The stack is generally divided into four layers: Senior Debt, Junior/Mezzanine Debt, Preferred Equity, and Common Equity. Seniority moves from top to bottom, while the cost of capital and potential returns move from bottom to top.

1. Senior Debt: Usually provided by banks; has the first claim on assets and the lowest interest rate. 2. Mezzanine Debt: Subordinated to senior debt; often includes 'equity kickers' like warrants to compensate for higher risk. 3. Preferred Equity: Higher claim than common stock but generally does not have voting rights. 4. Common Equity: The 'residual' claim; gets paid last but has unlimited upside potential.

In Chapter 11 bankruptcy proceedings, the Absolute Priority Rule states that senior creditors must be paid in full before any junior creditors or equity holders receive any value. In 2024, many distressed debt exchanges focused on 'priming' transactions, where companies attempted to issue new debt that would sit above existing senior lenders in the capital stack, leading to significant legal battles between hedge funds and corporate boards.